Fintech, Small Business & the American Dream

by Karen G Mills

  In the second period of ferment, as the innovation cycle continued to evolve, banks focused on reasserting their leadership in small business lending. Banks realized that they could remain major players because they had at least two important advantages over their fintech competitors. The first advantage was that banks had a pool of customers with whom they already had relationships—and the insights that come from these customers’ bank accounts, credit cards, and other bank activities. If a fintech lender like OnDeck could build a company based on data from small business bank accounts, why couldn’t the banks that actually hold those accounts use that same data to rebuild their lending processes? The second was that banks had access to lower cost capital in the form of customer deposits. The greatest challenge for the banks would of course be how to change—how to bring new ideas and technologies into a traditional culture in order to better serve their small business customers.

  Data and the Entrance of Technology Companies

  One of the breakthroughs that enabled the first phase of small business lending innovation was access to data through APIs. Data will also be the driver behind the next set of transformations in small business lending. Big data is increasingly used across multiple industries to better understand customers, competitors, trends, and more. The question is how better data will impact small business lending.

  One area is in the credit decision—can the business repay the loan? Additional data to drive better risk assessment could be particularly valuable in small business credit scoring, since small business creditworthiness is difficult to assess due to the heterogeneity and information opacity of small businesses that we discussed earlier. Already, online lenders have begun gathering and analyzing information about small businesses from non-traditional sources. Banks have now begun to look at the bank account payments and credit card activities of their customers to get a more holistic and timely picture of the small business’s financial health and ability to repay.

  But making the data useful requires algorithms that can utilize it to consistently and accurately predict risk. Although greater availability and multiple sources of data will certainly help, businesses are so different, and their profitability so volatile, that it is not yet clear how to create algorithms that work through the ups and downs of business cycles and maintain accuracy while accounting for the large amount of heterogeneity in small business.

  Perhaps the players in the best position to accomplish such a task are large technology platform companies like Amazon and Square. Amazon knows how much the companies on its platform are selling, their cash needs for inventory, and even how their competitors are performing. Square knows their business customers’ receipts in real time. These companies also have no issue attracting talented software engineers to build and test new algorithms, while traditional banks often struggle to recruit this talent. And, in contrast to the customer acquisition issues of new fintech start-ups, platforms like Amazon and Square are embedded into the finances and daily operations of many small businesses. They can suggest modifications that seasonality or weather fluctuations might require, and lend the cash to support those investments. Square’s MCA products even take their loan repayments from the money that passes through Square’s own payment systems, giving them direct access to the collateral that supports their advances.

  Reaching “Small Business Utopia”

  The early fintech innovators responsible for pushing the small business lending market to a more automated, easy-to-use process may not be the ones to benefit the most from their innovations. This is not unusual. Henry Ford did not invent the automobile, but he dramatically improved the processes by which they were made, and reaped profits and fame as a result. Once told that The Velvet Underground, the seminal 1960s rock band, had only sold 30,000 copies of their debut album, famed musician and producer Brian Eno retorted that “everyone who bought one of those 30,000 copies started a band.”19 Those who change the world do not always profit most from their actions.

  The early innovations in small business lending, enabled by entrepreneurs using new sources of data and rethinking the customer experience, have proven not to be the end of the road, but rather, an early stage. It may also be the case that the partnerships between fintechs and banks, and even the improvements banks have made internally, are only incremental though positive steps toward the ultimate small business lending solutions. As in the story of the transistor and the chip, another set of transformative inventions has already become visible—ones that will push this market to achieve its full potential to change the game for small businesses.

  We call the end point of this transformation “Small Business Utopia,” a state in which the entire financial life of a small business is transformed in a positive way by new technology and innovative tools that meet their needs. In Small Business Utopia, a truly efficient market, operating under appropriate regulatory oversight, will ensure that every creditworthy small business has customer-friendly access to the capital they need to start and grow their business and create jobs.

  In addition, this optimal small business environment will give business owners access to new insights on the cash needs of their businesses. This will allow them to be able to take on the right type of capital at the right time, the right price, with the right duration, and use it in a way that maximizes their operating potential. This future state will also benefit lenders, as the costs to make a small business loan will be lower, the risk of default will decrease, and the successful borrower will then likely be a repeat customer for a future loan as their business continues to grow and succeed.

  Takeoff: Small Business Lending of the Future

  What will be the “chip” of the small business lending story? Platforms such as Amazon, PayPal, and Square will certainly play a role in the new landscape. China has already shown us a model where such actors can dominate. Some traditional players—most notably American Express with its “OPEN” platform, Capital One, and the large banks—with strong small business franchises are also poised to potentially play a role.

  But as we move into the next phase of the innovation cycle, there is one additional factor that could determine the winners. The first stages of innovation came from entrepreneurs who saw and understood the pain points of the small business customer. Making the loan experience faster and easier was a breakthrough that got the attention of small businesses and started the chain reaction of industry response. The next phase of innovation will include a solution to another critical small business pain point: the fact that today, there is no tool, no platform, or set of services that provides a small business with a central place to conduct all of its financial activity in an integrated, easy-to-use way.

  Small businesses often get in trouble because of unexpected cash flow shortfalls. A late customer payment or an unusual inventory need can cause a sudden demand for financing. Most small business owners have low cash buffers. But what if they could see and understand their financial situation and needs more easily? And what if they could borrow the right amount with the right terms at the press of a button? What if they had one dashboard from which to conduct all of their financial activities? Such a platform would include integration of banking activity, cash flow insights and management, and payments processing. It would allow accounting software and tax planning tools to communicate seamlessly with bill paying and retirement planning functions. Artificial intelligence—or even personal advisors—could provide insights and options, based on a holistic picture of the small business.

  This is the true vision of Small Business Utopia, where small businesses can run their operations with greater success and longevity. The successful lenders of the future will allow small business owners to better understand what their financing needs are, and access capital quickly and at a competitive and transparent cost. This future may sound distant and difficult to achieve, but the technology required to make it a reality exists today.

  Getting to Small Business Utopia will not be easy, in part be
cause many innovations have unintended consequences. Lead was added to paint to make it more water resistant, maintain its color, and dry faster, and added to gasoline to reduce engine knock and boost octane. However, after it became increasingly clear that lead in the environment was a major health hazard, the government began phasing out leaded gasoline in 1974 and banned lead in paint for consumer use in 1978. Even the technological innovations that have allowed us to connect with anyone in the world, get groceries delivered right to our doorstep, and search the web for any information we desire, have also brought with them new issues of data privacy and cybersecurity.

  There is abundant evidence that innovation in finance can have negative, or even disastrous, outcomes. The market for over-the-counter derivatives—financial products often used to manage risk that were designed and sold in customized transactions rather than on publicly traded exchanges—grew exponentially in the decade prior to the financial crisis. Many financial firms reaped huge profits through the creation of ever-more-complex products that, in some cases, made the financial system more fragile and vulnerable to collapse. In the fintech innovation cycle, decisions that are rational to individual banks and borrowers may, at the same time, prove collectively destabilizing to the broader financial system. Unfortunately, we have seen the consequences to the economy—and particularly to small businesses—of operating without a well-functioning regulatory structure.

  On the other hand, we also have seen that too much or the wrong kind of regulation can impede innovation, particularly in the heavily regulated banking sector. Thus, to achieve the best outcomes, we must develop government policy that promotes innovation while protecting consumers, small businesses, and the financial system.

  * * *

  The innovation cycle in small business lending has gathered steam because technology has delivered new breakthroughs that reduce the long-standing frictions in the ability of new and old lenders to serve the market. In Chapter 7, we describe how the activities of the early fintechs ushered in these changes. In Chapter 8, we take a further look at the future of small business lending and what a new unified small business financial platform might look like. Given these existing and potential transformations, Chapter 9 explores strategic options for the traditional banks. Finally, Chapters 10 and 11 describe the state of the regulatory system that governs small business lending in the United States, and suggest principles for regulatory reform to increase the likelihood of successfully and safely achieving the heights of the small business lending innovation cycle that these early stages have promised.

  The cycle of Schumpeter’s creative destruction is only midway through its course. The best results for small businesses lie ahead.

  © The Author(s) 2018

  Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_7

  7. The Early Days of Fintech Lending

  Karen G. Mills1

  (1)Harvard Business School, Harvard University, Boston, MA, USA

  Karen G. Mills

  Email: kmills@hbs.edu

  In June 2013, about 350 people gathered in the Empire Room at Convene Innovation Center in New York to take part in the first ever LendIt conference. Co-founded by Peter Renton, the head of Lend Academy, the one-day event featured a keynote by Lending Club founder and then-CEO Renaud Laplanche. His speech, entitled Transforming the Banking System, told participants that they had the opportunity to emulate disruptive companies such as Netflix and Amazon, and to reshape financial services. Later panel discussions focused on direct and peer-to-peer small business lending models, using better data to make lending safer and more profitable, and exploring why venture capitalists were funding online lending companies. The day ended with a cocktail reception, and the entire event concluded by 7:30 PM.1,2 Almost all of the small family of fintech lending players attended, but banks and other traditional lenders were notably absent.

  The response to this first conference was so positive that Renton and his team turned it into an annual event. In May 2014, the second LendIt conference was a two-day affair that took place at the San Francisco Hilton. Interest had exploded to around 950 in-person attendees and nearly 2,000 watching online. The substance became more specialized, with sessions on small business and short-term lending, loan securitization, peer-to-peer lending in other countries, crowdfunding, and even a Q&A on legal and accounting issues. Significant attention was paid to longer-term industry trends regarding credit underwriting models and the use of big data. Some international fintech issues were touched upon, but most of those were saved for the LendIt conferences in Europe and China that started in 2014 and 2015, and also became annual events.3

  By 2015, the conference had grown to 2,500 attendees, including banks and credit unions. It featured sessions on “Borrower Acquisition at Scale” and “Partnering with Banks.”4,5 Former U.S. Treasury Secretary and Lending Club board member, Larry Summers, predicted in his keynote that fintechs would take over 70 percent of the small business lending market.6 The fintech disruption had been launched.

  The Frictions of Small Business Lending

  Lending to small businesses has always been much more difficult than lending to consumers for two reasons that we have discussed at some length in Part I: the heterogeneity and the information opacity of small firms. Each small business has different characteristics based on industry, location, size, and business goals. Even small business owners themselves are often unsure about what their future cash flows and revenues will look like. As a result, it is difficult to develop a full and nuanced picture of a small business’s credit-related metrics: the size of their revenues, when they incur large expenses, how quickly they pay, and how their business is trending. This kind of information makes up what one investor called a “truth file”—a way of capturing the essence of the business’s future prospects.7 For small businesses, developing a truth file has always been notoriously difficult, particularly for smaller and newer firms.

  Around 2000, the development of new information interfaces, known as open APIs (application programming interfaces), helped trigger important changes in the quantity and quality of available information on small businesses. An open API is a connection that allows third-party developers to access selected data from a company’s site, which can be used to create new applications.8 In 2000, eBay became one of the first e-commerce companies to use an open API to make extensive information available on small businesses who were selling products on the website. This created a data pipe for online lenders to access information about a small business’s eBay sales. The entry of Plaid in 2012 provided a unified API for banking data, which allowed developers to access valuable transaction information and use it to build applications for the fintech ecosystem.9

  The new backend infrastructure altered some of the longstanding frictions in the small business lending market. With these breakthroughs in data access, online lenders could make better-informed underwriting decisions. In the past, underwriting largely depended on FICO (Fair Isaac Corporation) scores and tax returns, which were not a timely reflection of a business’s activity. With new data sources, real-time information once hidden from view or perhaps reported inaccurately by a small business became more visible to underwriters who could use it to better identify creditworthy borrowers.

  The First Movers

  The fundamental innovation was harnessing the power of the Internet and data, but the incidental innovations were almost as powerful. Enabled by technology and inspired by market need, fintech start-ups brought a new “digital first” approach to online small business lending starting in the late 2000s. This early period lasted through roughly 2013 and was dominated by a few first movers—including CAN Capital, Lending Club, Kabbage, and OnDeck—that each broke new ground in their own way. One common hallmark of the early players was the automated turnaround of online applications that were easy to fill out and created a much better customer experience. These fintechs also brought other new approaches to th
e market including risk-based pricing, different sources of capital, and twists to traditional products and services.

  Risk-Based Pricing

  Many credit CAN (Credit Access Network) Capital, founded in 1998, with inventing the merchant cash advance (MCA). The original MCA products relied on a patented technology that allowed credit card receipts to be split between multiple parties.10 For a small business, this meant that a percentage of its credit card sales could automatically be sent to the MCA provider in order to pay down the advance.

  CAN tapped into a market that banks often found too risky: small businesses with urgent cash needs. Since many small businesses experience frequent cash flow fluctuations and have low cash buffers, quick and responsive lenders, even expensive ones, were in high demand. CAN and other MCA lenders were able to extend credit to riskier borrowers using two approaches that traditional banks avoided. First, they used true risk-based pricing, adjusting the interest rate they charged for the perceived risk. Banks have generally had narrow interest rate ranges, pricing loans largely based on what other banks are charging, and assessing risk primarily to make binary decisions about whether or not to lend, as opposed to the rate at which to lend. This has been due in part to the regulatory requirements that govern banks’ capital levels. Particularly after the recession, regulatory audits could classify a loan as too risky, and force it to be “qualified” or offset against the banks’ capital, making banks reluctant to take on a risky loan asset even if they could theoretically charge a high rate.